EMPLOYEE STOCK OWNERSHIP PLANS (ESOPS)

An Employee Stock Ownership Plan, or ESOP, is a qualified retirement
program through which employees receive shares of the corporation's
stock. Like cash-based retirement plans, ESOPs are subject to eligibility
and vesting requirements and provide employees with monetary benefits upon
retirement, death, or disability. But unlike other programs, the funds
held in ESOPs are invested primarily in employer securities (shares of the
employer's stock) rather than in a stock portfolio, mutual fund, or
other type of financial instrument.

ESOPs offer several advantages to employers. First and foremost, federal
laws accord significant tax breaks to such plans. For example, the company
can borrow money through the ESOP for expansion or other purposes, and
then repay the loan by making fully tax-deductible contributions to the
ESOP (in ordinary loans, only interest payments are tax deductible). In
addition, business owners who sell their stake in the company to the ESOP
are often able to defer or even avoid capital-gains taxes associated with
the sale of the business. In this way, ESOPs have become an important tool
in succession planning for business owners preparing for retirement.

A less tangible advantage many employers experience upon establishing an
ESOP is an increase in employee loyalty and productivity. In addition to
providing an employee benefit in terms of increased compensation, like
cash-based profit sharing arrangements do, ESOPs give employees an
incentive to improve their performance because they have a tangible stake
in the company. "Under an ESOP, you treat employees with the same
respect you would accord a partner. Then they start behaving like owners.
That's the real magic of an ESOP," explained one executive
in
Nation's Business.
Some experts also claim that ESOPs—more so than regular profit
sharing plans—make it easier for small businesses to recruit,
retain, and motivate their employees.

GROWTH OF ESOPS

The first ESOP was created in 1957, but the idea did not attract much
attention until 1974, when plan details were laid out in the Employee
Retirement Income Security Act (ERISA). The number of businesses
sponsoring ESOPs expanded steadily during the 1980s, as changes in the tax
code made them more attractive for business owners. Though the popularity
of ESOPs declined during the recession of the early 1990s, it has
rebounded since then. According to the National Center for Employee
Ownership, the number of companies with ESOPs grew from 9,000 in 1990 to
10,000 in 1997. By 1999, there were 11,000 ESOPs with a total of 9.5
million employee owners, according to the national ESOP Association. This
steady growth stems not only from the fundamental strength of the economy
during the 1990s, but also from small business owners' recognition
that ESOPs can provide them with a competitive advantage in terms of
increased loyalty and productivity.

ESOP SPECIFICS

In order to establish an ESOP, a company must have been in business and
shown a profit for at least three years. One of the main factors limiting
the growth of ESOPs is that they are relatively complicated and require
strict reporting, and thus can be quite expensive to establish and
administer. According to
Nation's Business,
ESOP set up costs range from $20,000 to $50,000, and there may be
additional fees involved if the company chooses to hire an outside
administrator. For closely held corporations—whose stock is not
publicly traded and thus does not have a readily discernable market
value—federal law requires an independent evaluation of the ESOP
each year, which may cost $10,000. On the plus side, many plan costs are
tax deductible.

Employers can choose between two main types of ESOPs, loosely known as
basic ESOPs and leveraged ESOPs. They differ primarily in the ways in
which the ESOP obtains the company's stock. In a basic ESOP, the
employer simply contributes securities or cash to the plan each
year—like an ordinary profit-sharing plan—so that the ESOP
can purchase stock. Such contributions are tax-deductible for the employer
to a limit of 15 percent of payroll. In contrast, leveraged ESOPs obtain
bank loans to purchase the company's stock. The employer can then
use the proceeds of the stock purchase to expand the business, or to fund
the business owner's retirement nest egg. The business can repay
the loans through contributions to the ESOP that are tax-deductible for
the employer to a limit of 25 percent of payroll.

An ESOP can also be a useful tool in facilitating the buying and selling
of small businesses. For example, a business owner nearing retirement age
can sell his or her stake in the company to the ESOP in order to gain tax
advantages and provide for the continuation of the business. Some experts
claim that transferring ownership to the employees in this way is
preferable to third-party sales, which entail negative tax implications as
well as the uncertainty of finding a buyer and collecting installment
payments from them. Instead, the ESOP can borrow money to buy out the
owner's stake in the company. If, after the stock purchase, the
ESOP holds over 30 percent of the company's shares, then the owner
can defer capital-gains taxes by investing the proceeds in a Qualified
Replacement Property (QRP). QRPs can include stocks, bonds, and certain
retirement accounts. The income stream generated by the QRP can help
provide the business owner with income during retirement.

ESOPs can also prove helpful to those interested in buying a small
business. Many individuals and companies choose to raise capital to
finance such a purchase by selling nonvoting stock in the business to its
employees. This strategy allows the purchaser to retain the voting shares
in order to maintain control of the business. At one time, banks favored
this sort of purchase arrangement because they were entitled to deduct 50
percent of the interest payments as long as the ESOP loan was used to
purchase a majority stake in the company. However, this tax incentive for
banks was eliminated with the passage of the Small Business Jobs
Protection Act.

In addition to the various advantages that ESOPs can provide to business
owners, sellers, and buyers, they also offer several benefits to
employees. Like other types of retirement plans, the employer's
contributions to an ESOP on behalf of employees are allowed to grow
tax-free until the funds are distributed upon an employee's
retirement. At the time an employee retires or leaves the company, he or
she simply sells the stock back to the company. The proceeds of the stock
sale can then be rolled over into another qualified retirement plan, like
an Individual Retirement Account (IRA) or a plan sponsored by another
employer. Another provision of ESOPs gives participants—upon
reaching the age of 55 and putting in at least ten years of
service—the option of diversifying their ESOP investment away from
company stock and toward more traditional investments.

The financial rewards associated with ESOPs can be particularly impressive
for long-term employees who have participated in the growth of a company.
Of course, employees encounter some risks with ESOPs, too, since much of
their retirement funds are invested in the stock of one small company. In
fact, an ESOP may become worthless if the sponsoring company goes
bankrupt. But history has shown that this scenario is unlikely to occur:
only 1 percent of ESOP firms have gone under financially in the last 20
years.

WHO SHOULD ESTABLISH AN ESOP

Although 1996 legislation opened the door for S corporations to establish
ESOPs, the plans continue to be much more attractive for C corporations.
In general, ESOPs are likely to prove too costly for very small companies,
those with high employee turnover, or those that rely heavily on contract
workers. ESOPs might also be problematic for businesses that have
uncertain cash flow, since companies are contractually obligated to
repurchase stock from employees when they retire or leave the company.
Finally, ESOPs are most appropriate for companies that are committed to
allowing employees to participate in the management of the business.
Otherwise, an ESOP might tend to create resentment among employees who
become part-owners of the company and then are not treated in accordance
with their status.

FURTHER READING:

Burzawa, Sue. "ESOPs Pay Off for Employers, as well as
Employees."
Employee Benefit Plan Review.
July 1999.